Accounting
Professor Siew Hong Teoh and Ph.D. Student Peng-Chia Chiu
Title: "Board Interlocks and Earnings Management Contagion"
Co-author: Feng Tian
Accepted at: The Accounting Review
Dectember 2012
We test whether earnings management spreads between firms via shared directors. We find that a firm is more likely to manage earnings when it shares a common director with a firm that is currently managing earnings and is less likely to manage earnings when it shares a common director with a non-manipulator. Earnings management contagion is stronger when the shared director has a leadership or accounting-relevant position (e.g., audit committee chair or member) on its board or the contagious firm’s board. Irregularity contagion is stronger than error contagion. The board contagion effect is robust to controlling for endogenous matching of firms with directors, fixed firm/director effects, incidence of M&A, industry, and contagion via a common auditor or geographical proximity. These findings support the view that board monitoring plays a key role in the contagion and quality of firms’ financial reports.
Professors David Hirshleifer and Siew Hong Teoh
Title: “Overvalued Equity and Financing Decisions"
Co-author: Ming Dong
Accepted at: The Review of Financial Studies
September 2012
We test whether and how equity overvaluation affects corporate financing decisions using an ex ante misvaluation measure that filters firm scale and growth prospects from market price. We find that equity issuance and total financing increase with equity overvaluation; but only among overvalued stocks; and that equity issuance is more sensitive than debt issuance to misvaluation. Consistent with managers catering to maintain overvaluation and with investment scale economy effects, the sensitivity of equity issuance and total financing to misvaluation is stronger among firms with potential growth opportunities (low book-to-market, high R&D, or small size) and high share turnover.
Professor Devin Shanthikumar
Title: "The Stock Selection and Performance of Buy-Side Analysts"
Co-authors: Boris Groysberg, Paul Healy, and George Serafeim
Accepted at: Management Science
September 2012
Prior research on equity analysts focuses almost exclusively on those employed by sell-side investment banks and brokerage houses. Yet investment firms undertake their own buy-side research and their analysts face different stock selection and recommendation incentives than their sell-side peers. We examine the selection and performance of stocks recommended by analysts at a large investment firm relative to those of sell-side analysts from mid-1997 to 2004. We find that the buy-side firm’s analysts issue less optimistic recommendations for stocks with larger market capitalizations and lower return volatility than their sell-side peers, consistent with their facing fewer conflicts of interest and having a preference for liquid stocks. Tests with no controls for these effects indicate that annualized buy-side Strong Buy/Buy recommendations underperform those for sell-side peers by 5.9% using market-adjusted returns and by 3.8% using four-factor model abnormal returns. However, these findings are driven by differences in the stocks recommended and their market capitalization. After controlling for these selection effects, we find no difference in the performance of the buy- and sell-side analysts’ Strong Buy/Buy recommendations.
Professor Devin Shanthikumar
Title: "Consecutive Earnings Surprises: Small and Large Trader Reactions"
Accepted at: The Accounting Review
June 2012
Prior research demonstrates that investors respond differently to earnings surprises that are part of a string of consecutive earnings increases or surprises than to those that are not. To shed light on who values these patterns, I compare trading responses of small and large traders to earnings surprises that occur during a series of positive or negative surprises. I find that the relative intensity of small traders’ trading (and to a lesser extent medium traders) to earnings surprises generally increases as a series progresses. Small traders respond more negatively to the second (third) negative surprise in a series than to the first (second), and more positively for the first three surprises in a positive series. Moreover, I find that announcement period returns are related to the trading of small and medium traders. These results suggest that less sophisticated smaller traders, responding to earnings series, contribute to previously documented pricing patterns.
Professor Terry Shevlin
Does Voluntary Adoption of a Clawback Provision Improve Financial Reporting Quality?
Co-Authors: Ed deHaan and Frank Hodge
Forthcoming in Contemporary Accounting Research
Accepted May 2012
We examine whether financial reporting quality improves after firms voluntarily adopt a compensation clawback provision. Clawback provisions allow companies to recoup excess incentive pay in the event of an accounting restatement, and are intended to ex ante deter managers from publishing misstated accounting information and to ex post penalize managers who do so. For the period 2007 – 2009, our difference-in-differences analysis reveals significant improvements in both actual and perceived financial reporting quality following clawback adoption, relative to a propensity-matched set of control firms. We also find an increase in compensation for CEOs who are subject to new clawback provisions, as well as an increase in the sensitivity of cash compensation to accounting performance. In cross-sectional tests, our findings indicate that “robust” clawback provisions, those that apply to restatements caused by either intentional or unintentional errors, have an incrementally larger impact on financial reporting quality and compensation than do clawback provisions that apply only to restatements involving fraud.
Professors David Hirshleifer and Siew Hong Teoh
Title: “Are Overconfident CEOs Better Innovators?"
Co-author: Angie Low
Accepted at: The Journal of Finance
January 2012
Previous empirical work on adverse consequences of CEO overconfidence raises the question of why firms would hire overconfident managers. Theoretical research suggests a reason, that overconfidence can sometimes benefit shareholders by increasing investment in risky projects. Using options- and press-based proxies for CEO overconfidence, we find that over the 1993-2003 period, firms with overconfident CEOs have greater return volatility, invest more in innovation, obtain more patents and patent citations, and achieve greater innovative success for given research and development (R&D) expenditure. Overconfident managers only achieve greater innovation than non-overconfident managers in innovative industries. Our findings suggest that overconfidence may help CEOs exploit innovative growth opportunities.
Professor Alexander Nekrasov
Title: “Using Earnings Forecasts to Simultaneously Estimate Firm-Specific Cost of Equity and Long-Term Growth”
Co-author: Maria Ogneva
Accepted at: The Review of Accounting Studies
August 2011
A growing body of literature in accounting and finance relies on implied cost of equity (COE) measures. Such measures are sensitive to assumptions about terminal earnings growth rates. In this paper we develop a new COE measure that is more accurate than existing measures because it incorporates endogenously estimated long-term growth in earnings. Our method delivers COE (growth) estimates that are significantly positively associated with future realized stock returns (future realized earnings growth). Moreover, the predictive ability of our COE measure subsumes that of other commonly used COE measures and is incremental to commonly used risk characteristics. Our implied growth measure fills the void in the earnings forecasting literature by robustly predicting earnings growth beyond the five-year horizon.
Professor Terry Shevlin
Tax Avoidance, Large Positive Temporary Book-Tax Differences, and Earnings Persistence
Co-Authors: Brad Blaylock, Ryan Wilson
Accepted at: The Accounting Review
July 2011
We investigate why temporary book-tax differences appear to serve as a useful signal of earnings persistence (Hanlon 2005). We first test and show that temporary book-tax differences provide incremental information over the magnitude of accruals for the persistence of earnings and accruals. We then opine that there are multiple potential sources of large positive book-tax differences. We predict and find that firms with large positive book-tax differences likely arising from upward earnings management (tax avoidance) exhibit lower (higher) earnings and accruals persistence than other firms with large positive book-tax differences. Finally, we find significant variation in current period earnings and accruals response coefficients and insignificant hedge returns in period t+1, consistent with investors being able to look through to the source of large positive book-tax differences (earnings management and tax avoidance), allowing them to correctly price the persistence of accruals for these subsamples.
Professor Lucile Faurel
Title: “Manager-Specific Effects on Earnings Guidance: An Analysis of Top Executive Turnovers.”
Co-authors: Francois Brochet and Sarah McVay
Accepted at: Journal of Accounting Research
July 2011
We investigate how managers contribute to the provision of earnings guidance by examining the association between top executive turnovers and guidance. Although firm and industry characteristics are important determinants of guidance, we conclude that CEOs participate in firm-level policy decisions, whereas CFOs are involved in the formation or discussion of guidance. Among firms that historically issued frequent guidance, breaks in guidance following CEO turnovers are relatively permanent and are potentially attributable to firm-initiated changes in guidance policy. Breaks following CFO turnovers, however, likely reflect uncertainty on the part of the newly appointed executive—they are concentrated in the two quarters following the turnover, are associated with the background of the newly appointed CFO, and extend to the relative precision of the guidance. Among firms that did not issue guidance historically, we find some evidence that newly appointed externally hired CEOs increase the likelihood of providing guidance.
Professors David Hirshleifer and Siew Hong Teoh
Title: “Limited Investor Attention and Stock Market Misreactions to Accounting Information”
Co-authors: Sonya Lim
Accepted at: Review of Asset Pricing Studies
April 2011
We document considerable return comovement associated with accruals after controlling for other common factors. An accrual-based factor-mimicking portfolio has a Sharpe ratio of 0.16, higher than that of the market factor or the SMB and HML factors of Fama and French (1993). According to rational frictionless asset pricing models, the ability of accruals to predict returns should come from the loadings on this accrual factor-mimicking portfolio. However, our tests indicate that it is the accrual characteristic rather than the accrual factor loading that predicts returns. These findings suggest that investors misvalue the accrual characteristic, and cast doubt on the rational risk explanation.
Professor Siew Hong Teoh
Title: “Data Truncation Bias, Loss Firms, and Accounting Anomalies”
Co-authors: Yinglei Zhang
Accepted at: The Accounting Review
February 2011
Ex post trimming of extreme returns observations that are not data errors causes spurious inferences in tests of market efficiency and behavioral explanations for anomalies. Trimming causes a downward truncation bias in estimated mean returns that is stronger in ex ante subsamples with more loss firms and in which return distributions are more right-skewed. There is an asymmetric U-shaped relation between return right-skewness and loss frequency across deciles of negative return predictors (Accruals, ΔNOA, and NOA), and a downward sloping relationship for positive return predictors (CFO and FCF). Consequently, a least-trimmed square (LTS) 1% deletion of returns induces a spurious inverted-U-shaped relation between returns and negative predictors, and an exaggerated positive relation for positive predictors. Thus, the resulting trimmed relations do not reject behavioral explanations for these anomalies. Trimming also induces a spurious loss anomaly. These findings highlight that in return prediction studies, observations should not be deleted based upon the values of the dependent variable, only based upon clearly identified data errors.
Professor Siew Hong Teoh
Title: “The Accrual Anomaly: Risk or Mispricing?”
Co-authors: David Hirshleifer and Kewei Hou
Accepted at: Management Science
December 2010
We document considerable return comovement associated with accruals after controlling for other common factors. An accrual-based factor-mimicking portfolio has a Sharpe ratio of 0.16, higher than that of the market factor or the SMB and HML factors of Fama and French (1993). According to rational frictionless asset pricing models, the ability of accruals to predict returns should come from the loadings on this accrual factor-mimicking portfolio. However, our tests indicate that it is the accrual characteristic rather than the accrual factor loading that predicts returns. These findings suggest that investors misvalue the accrual characteristic, and cast doubt on the rational risk explanation.
Professor Siew Hong Teoh
Title: “Short Arbitrage, Return Asymmetry and the Accrual Anomaly”
Co-authors: David Hirshleifer and Jeff Jiewei Yu
Accepted at: Review of Financial Studies
December 2010
We find a positive association between short-selling and accruals during 1988-2009, and that asymmetry between the up- and down- sides of the accrual anomaly is stronger when constraints on short-arbitrage are more severe (low availability of loanable shares as proxied by institutional holdings). Short arbitrage occurs primarily among firms in the top accrual decile. Asymmetry is only present on NASDAQ. Thus, there is short arbitrage of the accrual anomaly, but short sale constraints limit its effectiveness.
Professor Terry Shevlin
Real Effects of Accounting Rules: Evidence from Multinational Firms’ Investment Location and Profit Repatriation Decisions
Co-Authors: John Graham and Michelle Hanlon
Accepted at: Journal of Accounting Research
October 2010
We analyze survey responses from nearly 600 tax executives to better understand corporate decisions about real investment location and profit repatriation. Our evidence indicates that avoiding financial accounting income tax expense is as important as avoiding cash income taxes when corporations decide where to locate operations and whether to repatriate foreign earnings. This result is important in light of the recent research about whether financial accounting affects investment and in light of the decades of research on foreign investment that examines the role of cash income taxes but heretofore has not investigated the importance of financial reporting effects. Our analysis suggests that financial reporting is an important factor to be considered in the policy debates focused on bringing investment to the U.S.
Professor Terry Shevlin
Why Do CFOs Become Involved in Material Accounting Manipulations?
Co-Authors: Mei Feng, Weli Ge and Shuqing Luo
Accepted at: Journal of Accounting and Economics
September 2010
This paper examines why CFOs become involved in material accounting manipulations. We find that while CFOs bear substantial legal costs when involved in accounting manipulations, these CFOs have similar equity incentives to the CFOs of matched non-manipulation firms. In contrast, CEOs of manipulation firms have higher equity incentives and more power than CEOs of matched firms. Taken together, our findings are consistent with the explanation that CFOs are involved in material accounting manipulations because they succumb to pressure from CEOs, rather than because they seek immediate personal financial benefit from their equity incentives. AAER content analysis reinforces this conclusion.
Professor Terry Shevlin
The value of a flow-through entity in an integrated corporate tax system
Co-Author: Alex Edwards
Accepted at: Journal of Financial Economics
August 2010
In an integrated corporate tax system, resident shareholders receive a tax credit for corporate tax paid that can be used to offset personal tax on dividend income. Nonresident and tax-exempt (pension plan) investors cannot use the tax credit on corporate dividends and thus prefer to invest in flow-through entities. We estimate the value of the flow-through entity to nonresident and pension plan investors by examining the price change around the date of an unexpected announcement of a change in tax law related to Canadian publicly traded income trusts units creating an entity-level tax that makes them no longer tax-favored to these investors.
Professor Joanna Ho
Title: “The Impact of Management Control System on Efficiency and Quality Performance – An Empirical Study of Taiwanese Correctional Institutions”
Co-authors: Cheng-Jen Huang and Anne Wu
Accepted at: Asia-Pacific Journal of Accounting and Economics
May 2010
Management control system (MCS) has been widely suggested as a key framework with which organizations can utilize to increase the probability that people make decisions and take actions congruent with the entire goals of the organizations. Most of the previous studies have mainly focused on efficiency performance and we have little knowledge of the impact of management control systems on both quality and productivity performance. In this study, we use both non-parametric data envelopment analysis (DEA) and parametric stochastic frontier analysis (SFA) to examine how MCS affects efficiency and quality performance in correctional institutions. Our results show that correctional institutions in Taiwan have considerable technical inefficiency which is attributable to their unfavorable resource usage. We also find that correctional institutions with tight MCS have higher efficiency and quality performance. Our overall results support the argument that tight control systems can be used to achieve efficiency and quality performance.
Professor Joanna Ho
Title: “Corporate Governance and Returns on Information Technology Investment: Evidence from an Emerging Market”
Co-authors: A. Wu and Sean X. Xu
Accepted at: Strategic Management Journal
February 2010
Prior studies have reported mixed findings on the impact of corporate information technology (IT) investment on firm performance. This study investigates the effect of corporate governance, an important management-control mechanism, on the IT investment-firm performance relation in the Taiwanese electronics industry. Specifically, we explore board independence and foreign ownership, which have increasingly become salient factors concerning corporate governance in emerging markets. We address their roles across firms of different sizes and in industries where degrees of competitiveness run a wide gamut. Our results show a positive moderating effect of board independence on the IT investment-firm performance relation, especially when competition intensifies. Furthermore, we find that the greater the foreign ownership in small firms, the more positive the IT investment-firm performance relation, suggesting that foreign investors may bring IT expertise to help small firms reap the benefits of using IT.
Professor Lucile Faurel
Title: “Post Loss/Profit Announcement Drift”
Co-authors: Karthik Balakrishnan and Eli Bartov
Accepted at: Journal of Accounting and Economics
January 2010
We document a market failure to fully respond to loss/profit quarterly announcements. The annualized post portfolio formation return spread between two portfolios formed on extreme losses and extreme profits is approximately 21 percent. This loss/profit anomaly is incremental to previously documented accounting-related anomalies, and is robust to alternative risk adjustments, distress risk, firm size, short sales constraints, transaction costs, and sample periods. In an effort to explain this finding, we show that this mispricing is related to differences between conditional and unconditional probabilities of losses/profits, as if stock prices do not fully reflect conditional probabilities in a timely fashion.
Professor Alexander Nekrasov
Title: “Fundamentals-Based Risk Measurement in Valuation”
Co-authors: Pervin Shroff
Accepted at: The Accounting Review
October 2009
We propose a methodology to incorporate risk measures based on economic fundamentals directly in the valuation model. Fundamentals-based risk adjustment in the residual income valuation model is captured by the covariance of ROE with market-wide factors. We demonstrate a method of estimating covariance risk out of sample based on the accounting beta and betas of size and book-to-market factors in earnings. We show how the covariance risk estimate can be transformed to obtain the fundamentals-based cost of equity. Our empirical analysis shows that value estimates based on fundamental risk adjustment produce significantly smaller deviations from price relative to the CAPM or the Fama-French three-factor model. We further find that our single-factor risk measure, based on the accounting beta alone, captures aspects of risk that are indicated by the book-to-market factor and largely explains the “mispricing” of value and growth stocks. Our study highlights the usefulness of accounting numbers in pricing risk beyond their role as trackers of returns-based measures of risk.
Professor Siew Hong Teoh
Title: “Driven to Distraction: Extraneous Events and Underreaction to Earnings News”
Co-authors: David Hirshleifer and Sonya Seongyeon Lim
Accepted at: The Journal of Finance
October 2009
Recent studies propose that limited investor attention causes market underreactions. This paper directly tests this explanation by measuring the information load faced by investors. The investor distraction hypothesis holds that extraneous news inhibits market reactions to relevant news.We find that the immediate price and volume reaction to a firm’s earnings surprise is much weaker, and post-announcement drift much stronger, when a greater number of same-day earnings announcements are made by other firms. We evaluate the economic importance of distraction effects through a trading strategy, which yields substantial alphas. Industry-unrelated news and large earnings surprises have a stronger distracting effect.
Professor Joanna Ho
Title: “How Changes in Compensation Plans Affect Employee Performance, Recruitment and Retention – An Empirical Study of A Car Dealership”
Accepted at: Contemporary Accounting Research
Co-authors: Ling-Chu Lee and Anne Wu
February 2009
Prior studies have examined how changes to a more performance-sensitive incentive scheme influence employees’ compensation and performance. However, they are examples from practice (e.g., Sears) of companies, changing to less performance-sensitive incentive schemes. This study reports that a change from performance-sensitive (commission-based) scheme to less performance-sensitive (base salary plus commission) scheme hurts employee performance. We use performance data for 4,392 employees of a Taiwanese car dealership over a 56-month period. Our results show that higher-performing employees were affected by the compensation plan change more than lower-performing employees. Consistent with the predictions of selection effects, our results indicate that the less performance-sensitive plan retained fewer higher-performing salespersons and led to the recruitment of lower-performing sales staff. We also find that the greater compensation loss for an employee, the more likely she was to leave the dealership. The decrease in individual productivity did not translate into lower overall company performance. Further analysis suggests that the company may have taken several steps (e.g., hiring more employees, changing the sales mix) to mitigate the losses resulting from lower individual productivity.
Professor Siew Hong Teoh
Title: “The Psychological Attraction Approach to Accounting and Disclosure Policy”
Co-author: David Hirshleifer
Accepted at: Contemporary Accounting Research
Winter 2009
We offer here the psychological attraction approach to accounting and disclosure rules, regulation, and policy as a program for positive accounting research. We suggest that psychological forces have shaped and continue to shape rules and policies in two different ways. (1) Good Rules for Bad Users: rules and policies that provide information in a form that is useful for users who are subject to bias and cognitive processing constraints. (2) Bad Rules: superfluous or even pernicious rules and policies that result from psychological bias on the part of the ‘designers’ (managers, users, auditors, regulators, politicians, or voters). We offer some initial ideas about psychological sources of the use of historical costs, conservatism, aggregation, and a focus on downside outcomes in risk disclosures. We also suggest that psychological forces cause informal shifts in reporting and disclosure regulation and policy, which can exacerbate boom/bust patterns in financial markets.
Professor Alexander Nekrasov
Title: “Fundamentals-Based Risk Measurement in Valuation”
Co-author: Pervin Shroff
Accepted at: The Accounting Review
October 2009
We propose a methodology to incorporate risk measures based on economic fundamentals directly in the valuation model. Fundamentals-based risk adjustment in the residual income valuation model is captured by the covariance of ROE with market-wide factors. We demonstrate a method of estimating covariance risk out of sample based on the accounting beta and betas of size and book-to-market factors in earnings. We show how the covariance risk estimate can be transformed to obtain the fundamentals-based cost of equity. Our empirical analysis shows that value estimates based on fundamental risk adjustment produce significantly smaller deviations from price relative to the CAPM or the Fama-French three-factor model. We further find that our single-factor risk measure, based on the accounting beta alone, captures aspects of risk that are indicated by the book-to-market factor and largely explains the “mispricing” of value and growth stocks. Our study highlights the usefulness of accounting numbers in pricing risk beyond their role as trackers of returns-based measures of risk.
Professor Siew Hong Teoh
Title: “Accruals, Cashflows, and Aggregate Stock Returns”
Co-authors: David Hirshleifer and Kewei Hou
Accepted at: Journal of Financial Economics
2009
This paper examines whether the firm-level accruals and cash flow effects extend to the aggregate stock market. In sharp contrast to previous firm-level findings, aggregate accruals is a strong positive time series predictor of aggregate stock returns, and cash flows is a negative predictor. In addition, innovations in accruals are negatively contemporaneoiusly correlated with aggregate returns, and innovations in cash flows are positively correlated with returns. These findings suggest that innovations in accruals and cash flwos contain information about changes in discount rates, or that firms manage earnings in response to marketwide undervaluation.
Professor Siew Hong Teoh
Title: “Systemic Risk, Coordination Failures, and Preparedness Externalities”
Co-author: David Hirshleifer
Accepted at: Journal of Financial Economic Policy
2009
Sometimes resources are badly employed because of coordination failures. Actions by decisionmakers that affect the likelihood of such failures are sometimes said to cause ‘systemic risk.’ We consider here the externality in the choice of ex ante risk management policies by individuals and firms: they are concerned with private risk, not with their contribution to systemic risk. One consequence is that individuals and firms become overleveraged from a social viewpoint. The recent credit crisis exemplifies the importance of this problem. The US tax system taxes equity more heavily than debt, and therefore exacerbates the bias toward overleveraging. A possible solution is to reduce or eliminate taxation of corporate income and capital gains. Preparedness externalities can also cause firms to become too transparent, and thereby subject to financial runs. We consider the implications for debates over fair value accounting.
Professor Morton Pincus
Title: “Earnings Management Strategies and the Trade-Off between Tax Benefits and Detection Risk: To Conform or Not to Conform?”
Accepted at: The Accounting Review
Co-authors: Brad Badertscher, John Phillips, Sonja Olhoft Rego
December 2008
This study extends earlier research concerned with whether and how managers exploit the generally greater discretion available under U.S. financial accounting standards vis-à-vis income tax rules to manage earnings (i.e., cook the books). In particular, the study investigates the prevalence of, and firm characteristics that impact the choice between, managing earnings upwards in ways that do or do not have current income tax consequences (respectively referred to as “book-tax non-conforming” or “book-tax conforming” earnings management). We analyze companies that restated their earnings for shareholder reporting purposes due to accounting irregularities and find that restating companies generally employed earnings management strategies that increased the earnings they reported to shareholders without increasing the companies’ taxable earnings. Moreover, we find that companies traded off the net present value of tax benefits against the net expected costs of being detected as an earnings manager.
Professor Siew Hong Teoh
Title: “Do Individual Investors Cause Post-Earnings Announcement Drift? Direct Evidence from Personal Trades”
Co-authors: David Hirshleifer, James N. Myers & Linda A. Myers
Accepted at: The Accounting Review (American Accounting Association)
2008
This study tests whether naïve trading by individual investors, or some class of individual investors, causes post-earnings announcement drift PEAD[1]. Inconsistent with the individual trading hypothesis, individual investor trading fails to subsume any of the power of extreme earnings surprises to predict future abnormal returns. Moreover, individuals are significant net buyers after both negative and positive extreme earnings surprises, consistent with an attention effect, but not with their trades causing PEAD. Finally, we find no indication that trading by individuals explains the concentration of drift at subsequent earnings announcement dates.
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